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The recent spike in yields on long-dated Treasuries, sparked by encouraging signs for the U.S. economy and the European debt crisis, put the heat on closed-end funds that invest in municipal bonds.

As Treasury yields go, so generally do yields of other fixed-income securities. And higher yields mean lower prices. But that was only part of the story. The main culprit was a sharp deterioration in the relationship between the prices at which the muni closed-ends change hands and the value of their underlying assets. Before the selloff, which began on March 12, the 254 closed-ends tracked by Morningstar were trading, on average, at a price 2.1% higher than the value of the investments they owned. Six days later, these funds were selling at a 3.6% discount, says Steven Pikelny, a Morningstar analyst.

Thus, even through "the underlying assets only fell about 1%," according to Stephen O'Neill, co-portfolio manager of $555 million no-load
RiverNorth Core Opportunity
Fund (ticker: RNCOX), shareholders were clobbered. Since the drop, prices have improved, as last week's Current Yield column noted.

While closed-end funds probably account for just 3% of the muni market, they have become extremely popular with bargain hunters seeking tax-exempt income. Over the past 10 years, the funds traded at an average discount of 3.5% to their underlying net asset value. Toward the end of 2010, yield-starved investors began bidding up the funds' prices, pushing the First Trust Municipal Closed-End Index nearly 30% higher by March 9 of this year. That set them up for a fall as rates climbed.

BUT EVEN AS THE FUNDS' SHARES SLID below their underlying net asset values, they still offered juicy income. In February, "the average municipal closed-end fund was paying 5.78%, tax-exempt," says Cecilia L. Gondor, executive vice president at Thomas J. Herzfeld Advisors, a Miami firm specializing in closed-ends.

Unlike open-end muni funds, which can be traded only once a day and whose managers must buy and sell bonds based on cash flow, the closed-ends have a fixed number of shares that can be bought or sold on an exchange throughout the trading day. The rub: investor sentiment, not the underlying value of the securities, plays a big role in determining discounts or premiums from net asset value. Investors can be burned badly by the spread, especially when everyone is trying to sell at once, as was the case recently.

Another danger: Many closed-end funds use leverage to boost returns. That's a killer when short-term rates start climbing faster than long-term rates. In that case, the leveraged funds usually cut payouts. That prompts some longtime investors to take profits, putting more downside pressure on the fund shares.

Gondor, who was buying during the panic, says "we have lightened up as prices have begun to recover and discounts narrow" again.

Bottom line: Investing in a closed-end muni fund now is a bet that rates won't rise. If they don't, share prices should stabilize, while buyers enjoy an average annual yield well above 5%, tax-free. But if rates do rise…